Illustration by Bloomberg View
Illustration by Bloomberg View

(Corrects EFSF name in eighth paragraph.)

Once upon a time, like this summer, Dexia SA, the French-Belgian bank, was stable. By the measures global regulators deem important, its capital ratio stood at 11.4 percent of risk-weighted assets, according to data compiled by Bloomberg. That’s well above the 10 percent regulators plan to require of the world’s largest banks under new international rules.

What a difference a summer makes. The Belgian and French governments now have a complicated mess on their hands. Dexia, which had received a government bailout in 2008, saw its shares plummet after Moody’s Investors Service put its main units on review for a downgrade on Oct. 3. Within days, Belgium and France said that they would stand behind the bank’s deposits and suggested a “bad bank” structure could be used to wind down its toxic assets.

How this will be resolved is unclear. But Dexia crystallizes the need for smarter capital rules, credible stress tests and an aggressive plan to recapitalize Europe’s banks quickly should financial calamity strike.

The first problem is that some risk-weighting methods can make banks look stronger than they really are. Global capital rules, for example, allow placing zero weight on government debt. Using equal weights for all assets (and excluding intangible assets such as goodwill), Dexia’s tangible common-equity ratio -- a simpler measure of capital -- amounted to less than 1 percent as of June 30, according to Bloomberg data. That’s less than half what Lehman Brothers had as of May 2008.

Stressed Out

The stress tests conducted by European banking regulators shared the same blind spot: they didn’t consider the prospect that banks could suffer losses as a result of sovereign defaults. In such a scenario, a mere 10 percent loss on Dexia’s 50-billion-euro net holdings of sovereign debt would wipe out its tangible equity. Instead, Dexia passed the second round of stress tests in July with flying colors. Even under the test’s worst-case scenario, Dexia’s capital ratio didn’t fall below 10 percent.

These flaws help explain why new measures to backstop Europe’s banking system will inspire little faith unless they are combined with an honest accounting of how much banks stand to lose if Greece and other struggling governments default. New stress tests, done honestly, will help determine how much a recapitalization of Europe’s banks is likely to cost.

Recapitalization Plan

Such a program would be legally complicated, potentially ineffectual and spectacularly unpopular. Policy makers must be prepared to undertake it anyway. To date, Europe’s leaders have shown little urgency or unity in confronting their debt problems. That needs to change. A recapitalization plan should be coordinated continent-wide. It should acknowledge potential writedowns of the sovereign debt of weak countries other than Greece. And it should be large enough to meet banks’ needs with overwhelming force -- about $200 billion by most estimates.

The structure of the plan will provoke intense debate. We’ve argued before that the European Financial Stability Facility should be leveraged with the help of the European Central Bank to create a bailout fund akin to the Troubled Asset Relief Program that the U.S. instituted in 2008. A proposal offered by German officials -- in which shareholders, national governments and the EFSF provide a system of rolling backstops, in that order -- also could be the basis of a credible plan.

In the best case, an authoritative recapitalization proposal would signal to markets that European officials were coming to grips with the scope of their problems -- thereby buying time to bring Greece to an orderly default and further protect solvent countries’ debt. In the worst case, it could be activated quickly to try to forestall a calamitous credit crunch.

Dexia’s most immediate problem has been a crisis of liquidity, and not capital. But the reason lending dried up was because markets recognized the bank’s precarious capital structure and vulnerability to deteriorating sovereign debt. One can’t be blamed for feeling Dexia isn’t alone.

To contact the Bloomberg View editorial board: view@bloomberg.net.